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Hedge Funds: practice question
Two hedge funds run the same strategy with the same expected gross return and the same fee schedule. The Petrel Fund is open to subscription and redemption monthly on ten days' notice. The Ardstone Fund imposes a two-year lock-up and then requires 90 days' notice for redemptions. When choosing between them, an investor is most likely to:
- require a higher expected net return from the fund with the lock-up as compensation for giving up access to capital
- prefer the fund with the lock-up, because restricting withdrawals lowers its operating costs and thus raises its net return
- treat the two funds as equivalent, because lock-up and notice terms affect the timing of cash flows but not the risk
Show answer and explanation
Correct answer: A
Explanation: A is correct: the two-year lock-up and 90-day notice period are liquidity restrictions that increase the risk borne by the investor, who cannot exit or redeploy capital, so the investor should demand a higher expected net return as compensation. B is incorrect because restrictions on withdrawals do not raise the investor's net return; they may give the manager stability, but the investor has surrendered access to the capital and is not compensated by the manager's cost savings. C is incorrect because the inability to withdraw is a genuine risk dimension — it determines whether losses can be cut and capital redeployed — so the two funds are not equivalent to the investor.
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